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Taxes at the Top

For many progressives it is an article of faith that tax rates on the richest Americans should be higher than they currently are.

Why? One reason is that it would be fairer. In the 1950s the top marginal income tax rate was 90%, and it was 70% as recently as 1980. These days the top rate is only 35%.

That’s misleading, however, because prior to the mid-1980s the tax system had a lot more loopholes and deductions than it does now. The meaningful tax rate is the “effective” rate — the share of their income that people actually pay in taxes. The following chart shows the top marginal rate and the average effective rate on the top 1% of taxpayers since World War II. The latter is from calculations by the Congressional Budget Office (here) and is only available beginning in 1979. (As of 2005, a four-person household in the top 1% had a pretax income of $600,000 or more.) The effective rate is lower now than it was in the late 1970s and in the mid-1990s.

Some opponents of higher tax rates for the rich argue that fairness in taxation requires that everyone’s income be taxed at the same rate. Taxation should be proportional rather than progressive. Not many people seem to share this view, however. Most feel that because they can afford to, the richest should pay not only more dollars but also a larger share of their income.

A second rationale for higher taxes on the most well-to-do is that it would increase government revenues, which could be used to help improve opportunity and outcomes for those less fortunate. Health care for all, a more generous Earned Income Tax Credit, and subsidized preschool and child care are among the many good ideas currently on the table.

The taxes paid by those at the top matter a great deal for government finances. As of 2005 the top 1% accounted for 28% of federal government tax revenues. That isn’t because they are taxed at an outlandish rate; an effective tax rate of 30-40% is hardly confiscatory. Instead, it’s because they get a very large share of the country’s income — 18% as of 2005.

The following chart shows federal government tax revenues as a share of GDP by the effective tax rate on the top 1%. The data points represent each year for which data are available. Although the correlation is far from perfect, tax rates on the richest are positively associated with the portion of GDP collected in taxes. This is as we would expect. It suggests that steeper tax rates at the top are likely to bring in more revenue.

But not so fast. It is commonly objected that higher tax rates on the affluent will reduce incentives for saving, investment, entrepreneurialism, and hard work. Economic growth will slow. Thus, taxes will be collecting a larger share of a less-rapidly-growing economy. In the end, higher tax rates will yield no increase (and perhaps a reduction) in government revenues.

Is this true? A lot of research has been done on this question, but there is little agreement about the answer. (For a helpful overview, see Joel Slemrod and Jon Bakija, Taxing Ourselves.)

The next chart shows the growth rate of per capita GDP by the effective tax rate on the top 1%. The effective tax rate on the richest appears to have had no noteworthy impact on economic growth. Averaging growth over several years does not change the picture.

What about the effect of tax changes? As the first chart above indicates, the effective tax rate on the top 1% fell sharply between 1979 and 1982. In the five-year period beginning in 1982 the growth rate of per capita GDP averaged 2.6%. By contrast, the effective rate on top incomes jumped appreciably between 1990 and 1995. Yet over the five-year period starting in 1995 the average rate of economic growth was virtually identical: 2.7%.

There have been several smaller changes in the high-end effective tax rate since the late 1970s. In the late 1980s the rate increased slightly, and in the late 1990s it declined slightly. In both of these instances, however, assessment is complicated by the fact that recessions occurred fairly shortly afterwards. More recently, between 2000 and 2005 the top rate was reduced from 33% to 31%. Per capita economic growth in the mid-2000s has been relatively weak for a non-recession period, at just a little more than 2% per year, but it is too early to fairly judge the impact.

To sum up: The effective tax rate on the incomes of the top 1% of Americans is substantially lower now (31%) than it was in the late 1970s (37%) and in the mid-1990s (36%). When the rate is higher, the federal government tends to collect a larger share of the national economy in taxes. And the experience of the past several decades suggests that higher rates have had no adverse impact on growth of the economy.

This evidence is by no means conclusive. But it lends credence to progressive hopes that a somewhat higher rate of taxation on the richest Americans would not only be fairer but also enhance the government’s ability to provide valuable services and benefits.

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34 thoughts on “Taxes at the Top”

I once met Bill Gates, Sr. at a meeting where he spoke on behalf of the Responsible Wealth Project. After the panel discussion, I asked if we might consider that the wealthy should pay a higher percentage of their income in taxes because they use a greater share of government services such as infrastructure, police, the courts, and even education. All of the businesses they own take advantage of those services. Mr. Gates came up to me after the meeting and said that maybe we should call the progressive tax a “proportional” tax instead.

Hi Lane – nice blog! There’s a point regarding progressive taxation that seems to be an implicit assumption of a progressive tax regime both from fairness and efficiency perspectives but is rarely if ever discussed explicitly. It seemed that you were about to raise the point when you said:
“Some opponents of higher tax rates for the rich argue that fairness in taxation requires that everyone’s income be taxed at the same rate. Taxation should be proportional rather than progressive. Not many people seem to share this view, however. Most feel that because they can afford to, the richest should pay not only more dollars but also a larger share of their income.”
It seems to me that that last sentence makes a much weaker argument than raising the question of diminishing marginal utility of income; i.e. that in order to tax everyone at the same level of utility requires a progressive system in which the rate would be the inverse of the function describing DMUI. Why isn’t this brought up by economists more frequently?

Good point. Some economists do make it — for example, Richard Layard in his book “Happiness.” Personally I find ability to pay a more compelling normative argument for a higher tax rate on high incomes.

Is there any research on the effect of cheating, hiding income, etc., on tax revenue and economic growth?

Perhaps higher tax rates on the rich don’t effect economic growth or revenue because the rich know how to hide assets and income. It could be that no-matter if taxes are officially 80%, or if taxes are officially 20%, that the rich only actually pay 10% in either situation.

The progressive assumption is that laws and regulations are followed to the letter… that if the tax rate is 70%, that people actually pay around 70%. I think that is a huge leap of faith.

If enforcement suddenly became perfect, tax rates that might have appeared to have no negative effect on revenue and economic growth with lax enforcement could become very damaging.

One other point in favor of progressive taxation is that income and wealth inequality appear to have negative social effects, regardless of the absolute level of income or wealth for those at the bottom. To the extent that progressive taxation aids in shifting money towards the relatively poor, it ameliorates some degree of those negatives. The folks over at Inequality.org track this sort of thing.

Completely without theoretical or empirical foundation is the claim that high marginal rates on the wealthy discourage economic activity.

After the Bush tax cuts of the early 2000’s, the revenue flow came in from the same people, the only difference is the federal government now has to pay debt service. The purchase of government bonds replaced taxes.

Nice post, and nice discussion. Re: Rex Rhino– while major overhauls of the tax code happen infrequently, post-overhaul revisions to the code occur very frequently, and the code is “tweaked” and amended several times in the years following amendment in order to deal with the cheating problems you properly raise. As my tax professor in law school said– “the IRS has already figured out what the cheats will be in 90% of the cases. The amendments to the code close the loopholes within a year in most of the cases.”

After the panel discussion, I asked if we might consider that the wealthy should pay a higher percentage of their income in taxes because they use a greater share of government services such as infrastructure, police, the courts, and even education.

But they already do. For example, the National Taxpayers Union claims that for 2005, the top 1% of earners paid 39.38% of all personal tax paid.

In my view, this means they more than paid for the share of the public largesses they consumed, and guess what, they provided employment for lots of other people as well.

1. The main reason why higher taxation, in most countries, does lead to lower revenues, is that capital flees. The US is a unique example in that the capital has nowhere to flee to. This is because the US has oppressive laws which not only tax its citizens’ worldwide income, but claim the right to tax expatriates for 10 years after they move out of the US. With the US (still) being the world’s largest economy, there’s not much else to do than stay where you are and pay the tax.

Of course, in your world, this is perfectly OK. The fact that wealthy individuals cannot even opt out of your tyranny works in your favor. It helps you at the expense of the few “well-to-do”, so these are policies you’d happily vote for.

2. The final graph you show – the one that correlates GDP growth with the effective tax rate – has an apparent downward slant. If you draw a best fit line over the points on that graph, it shows GDP growth dropping as the effective tax increases. You neglect to even notice that, and cherry-pick your data in an attempt to derive the opposite result.

3. While I would praise an unbiased attempt to illuminate bare economic facts, your post comes with more than just a little baggage. You compare tax rates today as “low” compared to “fair” tax rates of 70-90% in decades gone by:

“Why? One reason is that it would be fairer. In the 1950s the top marginal income tax rate was 90%, and it was 70% as recently as 1980. These days the top rate is only 35%.”

Lane, let me assure you: yourself saying that a 70-90% marginal tax rate is fair, stirs in me emotions similar to what yours would be if someone said they wish someone would rape and slaughter your baby.

I kid you not.

This is personal. There are some very fundamental reasons why a majority who feels that it’s OK to force a few choice individuals to pay for everyone’s government programs, should not be allowed to do so.

These reasons are much the same as why a majority who feel that gays should not be able to adopt children, should not be able to prevent them from doing so.

Everyone has a favorite oppression that they want to force on others. Everyone is also pissed at some oppression that they think is fundamentally unfair. But the real problem is that we live in a system where all it takes for an oppression to take place is that it gathers the support of some majority.

If you are in favor of gays’ rights, you should be against the income tax. Everything else is opportunism, and is unsound.

If Mr. Kenworthy genuinely believes that it is imperative for well-to-do individuals to share a majority of their income with those less fortunate;

if he genuinely believes that marginal tax rates up to 90% are fair;

then he should have no problem parting with his money voluntarily.

Mr. Kenworthy already pays some $15,000 of his income in taxes. If he wishes to demonstrate the strength of his belief in the fairness of a tax rate of 90%, he should show this by diverting most of the rest of his income – some $30,000 would do well – to charities that help people in third world countries.

This would still leave him with some $15,000, which is what poor people reasonably get by on in the U.S.

Once he has shown such solidarity with his less fortunate brothers, he will have demonstrated that what he extols comes truly out of his sense of decency and fairness.

However, if I venture a guess that Mr. Kenworthy is not willing to voluntarily forfeit the vast majority of his income to the benefit of his suffering less fortunate brothers,

then it follows that Mr. Kenworthy is endorsing these policies only under the assumption that he is on the receiving, not the paying, end of the tax wedge.

Just to be clear: I don’t favor a top marginal tax rate of 90% or even 70%. As I say in the post, the marginal rate is not what matters anyway. What matters, in terms of fairness and government revenues, is the effective rate. I’d prefer the effective rate on the top 1% of taxpayers to be around 36%, as in the mid-1990s, rather than the current 31%.

I don’t think those types of Ad Hominem attacks are really conducive to a rational discussion. If you have some problem with the methodology used by the National Taxpayers Union, then please bring it up. But “THEY DISAGREE WITH ME, SO THEY ARE A BUNCH OF RIGHT WING STINKERS!!!”, is just kind of childish name calling.

I very much agree with Lane Kenworthy’s conclusion that “when the rate is higher, the federal government tends to collect a larger share of the national economy in taxes”. I also agree that “the experience of the past several decades suggests that higher rates have had no adverse impact on growth of the economy”. I looked at both of these questions in regard to the Reagan tax cuts a few years ago and posted the resulting analysis at http://home.att.net/~rdavis2/taxcuts.html . As stated in the analysis, the evidence is that the Reagan tax cuts decreased revenues over what they would have been, at least over the short (8-year) term. Their effect on economic growth, however, is much more difficult to analyze. Still, I didn’t find any strong evidence that the Reagan tax cuts permanently affected the GDP one way or the other.

Lane also mentions that “it is commonly objected that higher tax rates on the affluent will reduce incentives for saving, investment, entrepreneurialism, and hard work”. This is the reverse of the often discussed question, “will a decrease in top-bracket income tax rates encourage work and investment, increasing growth?”. Following is an excerpt on this topic from page 116 of the book “The Coming Generational Storm”, co-written by economist Laurence Kotlikoff:

[START OF EXCERPT]There are two competing forces at play in determining whether pretax earning rise, stay the same, or fall. On the one hand, workers may say to themselves, “Boy, now that taxes are lower, I can work less and still receive the same after tax pay. I’m going to cut back my workweek.” On the other hand, they may say, “Boy, now’s a good time to work more and earn more because taxes are lower on every extra dollar I earn”. Economists call the first of these reactions the “income effect”. They call the second reaction, the “substitution” or “incentive effect”.

Some of the best labor economists in the country have spent their lifetimes measuring the income and substitution effects. The broad consensus of these experts is that the two effects are roughly offsetting. This means that if wage tax rates are cut by, say 15 percent, tax revenues will fall by 15 percent.
[END OF EXCERPT]

There are other offsetting effects. For example, tax cuts financed by borrowing may have a positive effect on the GDP by pumping additional money into the economy. But this may be offset over the long run by the resulting cost of servicing the additional debt. In addition, there may be seriously negative effects if the tax cuts are seen as unsustainable and/or to weaken the country’s financial condition. Even before the Bush tax cuts, the annual U.S. Budget was projecting that the federal debt would skyrocket over the next few decades (recent projections are at http://home.att.net/~rdavis2/pro2008.html ). Many therefore believe that these tax cuts are unsustainable. In any event, the point is that there are many possible effects of tax cuts, positive and negative. We need to carefully analyze the data and avoid jumping to conclusions about the relative size of those effects.

Thanks for the regression lines. Makes the charts much more illuminating. It’s darned interesting (but not terribly surprising) that the taxes-versus-growth line (almost flat, though it’s still comparing same-year data, rather than ensuing years) looks identical to the one I pulled for OECD countries over thirty years. (Linked above.)

At risk of presuming, could you also add regression lines to the three scatter plots in “Does More Equality Mean Less Economic Growth?” (Would pull them myself, but don’t have the data.) I’m working on a post on the subject, will be referencing yours.

The 39.38 figure appears to be correct but it is the total INCOME tax share paid by the top 1 percent in 2005, not the PERSONAL tax share as mentioned by Cynic. The latter would likely include payroll taxes. Still, I understand your skepticism with anything claimed by “think tanks”, especially those whose studies always seem to reach the same conclusions. If one makes such a claim, the most that I’ll do is look up their source and crunch the numbers myself. Looking at the link that was given, I see that the source was listed as the Internal Revenue Service but no more information was given. In fact, you can find the numbers on the IRS site at http://www.irs.gov/pub/irs-soi/05in05tr.xls. Why didn’t the National Taxpayers Union list the link? Perhaps they didn’t want you to see some of the other numbers there. For example, the spreadsheet shows that the top one percent paid 39.38% of total income taxes but also that they received 21.20% of all adjusted gross income. Hence, they paid a bit less than double what they would have paid under a flat tax. Also, the spreadsheet shows that their share of all adjusted gross income has risen from 11.30% in 1986 to 21.20% in 2005, nearly double. You can find more information on these statistics at http://home.ix.netcom.com/~rdavis2/richpay.html. The numbers in the article are for 2001. Following are the updated numbers for 2005:

Lane: if you think that an effective tax rate of 36% for the richest few percent is fair, but you are paying an effective income tax of say 21% (guessing); then, given that you are among the richest few percent of the world’s population, the right thing for you to do would be to volunteer the remaining 15% of your salary to help your African and Asian brethren.

If the rich people of the US should pay 36% of their income to help their less fortunate American brothers, then why should middle-income Americans not pay 36% to help their downtrodden brothers worldwide?

Unless it’s not really all a big brotherhood after all, but more so a wolf-eat-sheep situation – tax people because we can, or perhaps because we envy them, or because it’s convenient – not because we should?

I note that Citizens for Tax Justice has an article on the “overall tax rate.” They use a different analysis to obtain a different result. It’s dated 2004, so it should still be close to actual. They factor all taxes, state and local. The top one percent have an effective rate of 31% and the lowest quintile have a 19 % rate, and the majority pay a rate of 29%.
The state’s role in an economy is to maintain property rights and to provide “freedom from want,” in FD Roosevelt’s words. It becomes a subjective evaluation whether someone is paying too much or too little in taxes. Are working people undergoing hardships? What is poverty if not hardship? About a quarter of the jobs pay below the poverty level. Then the state should try to alleviate the hardships. It’s a value judgment to require the affluent to maintain those workers who are struggling for necessities. Also, economic growth may be served effectively with demand-led or wage-led growth ensuring adequate aggregate demand. See Jeff Madrick at Challenge Magazine. So morally and in terms of economic growth there are arguments for taxing the wealthy more than the poor.

Very well put together! I think that taxes should be fair, and those who make the most should pay the most. I’d imagine that a lot of the taxes on the super rich are not actually captured. I know one poster mentioned that the “loopholes” are fixed pretty quickly, but I’d think a lot still goes past the radar, especially with the way the IRS has had it’s hands tied by the prior administration!

I was horrified to discover my effective tax rate for 2010 is 36%, thanks to AMT, which prevents me from deducting property tax, kids, etc.. I live in CA, so I am “rich”. In reality I’ve never had so little money left over. The AMT system is designed to screw the middle class, and completely bypasses the Bush tax-cuts. All that posturing by both sides was BS! My property taxes are $15k a year…not getting to deduct that is an enormous difference from when I could.

It seems so simple. The 1950s was a decade of high economic growth and high tax rates. So why not go back to those tax rates and also return to an economic Golden Age? Higher taxes would, theoretically, generate more tax revenue to reduce budget deficits or finance new social programs to reduce income inequality. And as the 1950s example shows, the economy can do just fine if rich folks pay a lot more to Uncle Sam—even a whole lot more.

Sounds good to David Levine, former chief economist at Sanford C. Bernstein and a fellow, according to The Washington Post, who wants to put tax policy in a souped-up DeLorean and go back to the future! “I was a kid in the 1950s,” says Levine, “and the whole time, the top marginal tax rate was 87 percent.” Levine is a supporter of Responsible Wealth, which is, according to the group’s web site, “a network of over 700 business leaders and wealthy individuals in the top five percent of income and/or wealth in the U.S. … Their message is simple, and surprising to some: we can afford to pay more; we don’t need any more tax breaks.”

The top marginal tax rate was 91% during the 1950s. Here’s why we can’t go back:

1. The 1950s was no Golden Age. The U.S. economy grew by an average of 3.4% a year between 1948 and 2007. How did the 1950s do in comparison? If you measure the 1950s from 1950 to 1959, it did a bit better than average, growing at an annual rate of 3.6%. If you measure the decade from 1951 to 1960, it grew at a below average 3.0% rate. The period also saw three recessions, July 1953-May 1954, August 1957-April 1958, and April 1960-February 1961. Now, overall, it was a strong period for the economy, especially for folks with still-fresh memories of the Great Depression. But recall that John F. Kennedy’s 1960 presidential campaign said he would “get this country moving again.” That’s a slogan a politician uses after a decade of stagnation, not hypergrowth. (Of course, JFK sharply cut taxes and the economy boomed.)

2. Real tax rates were a lot lower. Even Levine concedes that “not many people paid that much. Only three baseball players — Ted Williams, Joe DiMaggio and Willie Mays — got there.” Indeed, the top effective tax rate was probably somewhere between 50-60% because of a tax code full of loopholes. Now, that’s still higher than today’s top effective tax rate of around 30%. But those 1950s tax rates actually generated less tax revenue than subsequent periods of lower rates. From 1950 to 1963, income tax revenue averaged 7.5 percent of GDP; that’s less than in the Reagan years when rates were being slashed. This could suggest that rates are right around the Laffer Curve equilibrium point in the current economy. Indeed, the following chart from the WSJ makes this calculation over a variety of time periods